2013 and The Evolution of Crowdfunding

Last Week, Wired.com reported that the entrepreneurs who raised $139,070 on Kickstarter to create POP, a multi-device charging station, were returning all the money they raised because Apple is forbidding the inclusion of non-Lightning adapters with its new Lightning connector. This refund marks the largest ever for a project that raised money on Kickstarter.

While some are heralding this as a big blemish on the façade of crowdfunding, we think these critics are completely missing the positive significance of the refund. As the New York Times reported in September, many projects that have raised money on donation-based crowdfunding platforms have struggled to meet their development timelines, leaving donors frustrated, and disillusioned with crowdfunding. By refunding money like POP did, I believe the company’s 1,000 donors are actually more likely to crowdfund again than if POP either delivered a product with significant delays, delivered a product consumers didn’t want, or simply could not deliver a product. Donation and equity based crowdfunding, like angel investing, is inherently risky—if it was not risky than those who seek crowdfunding would be able to raise money via bank loans or traditional financing mechanisms. Successful crowdfunding platforms will have to evolve to reflect the inherent risks of crowdfunding, or they will not survive. Kickstarter is a prime example of a platform that has evolved to reflect the risks of the business. For example, in September, Kickstarter introduced a new section on every project’s page where the person raising money must disclose “Risks and Challenges”. Additionally, Kickstarter prohibited projects from displaying simulations or renderings of products—actual photos of prototypes are now required, so as to lessen the execution risk. Perhaps Kickstarter’s next evolution is an easy refund mechanism or a project’s funding being held in escrow and released when specific milestones are hit. Whatever Kickstarter does, it will continue to evolve to address the risks of crowdfunding, or else it won’t survive.

To take this incident a step further, suppose there was outright fraud and the POP entrepreneurs kept the $139,070 and did not deliver a product (this is a hypothetical—this clearly did not happen). Would this have meant the end of crowdfunding? No. Fraud will happen in crowdfunding. It happens in every industry—from highly regulated public capital markets to product listings on eBay and Craigslist. Fraud is as old as business itself and every industry has experienced it at some point. The goal is to minimize the chances of fraud occurring and the impact it has on the integrity of the system overall. To that end, crowdfunding has a lot of advantages.

The SEC will soon issue proposed rules to help limit fraud in crowdfunding. The Jobs Act provides some clear constraints, such as capping the amount a company can raise via equity-based crowdfunding at $1 million in a year, and requiring a number of significant disclosures on a transparent funding portal where any investor can see and scrutinize them. By requiring the portals themselves to register with both the SEC and a self-regulatory organization (likely FINRA), lawmakers have ensured the portals will have to adhere to a higher standard which should help to limit (but will not eliminate) fraud. More fundamentally, the transparency provided by uniform disclosures to a wide network of potential funders inherently limits fraud.

Beyond fraud, we at CircleUp, an equity-based crowdfunding platform currently operating with accredited investors, also believe the management teams of the funding portals have a critical role to play. Kickstarter screens potential projects, rejecting those that don’t met their criteria. For equity based crowdfunding, this curation role is vitally important. We believe the managers of equity based portals should have the securities and investing sophistication needed to help issuers sell securities. Transparency, as mentioned above, will help, as will certain requirements like background checks of the entrepreneurs and investors.